This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

Top 5 Retirement Issues

Investment Advisor spoke with top players throughout the retirement industry to get their take on the biggest issues in retirement planning

When retirements were buoyed by employer-sponsored pensions and a robust Social Security, the most difficult challenge earlier generations of retirees had to face was how to fill their hours when they got tired of playing golf. Modern retirement is more precarious. As the responsibility for paying for retirement shifts off employers’ shoulders and on to employees’—and to some degree, advisors’—myriad challenges emerge.

Between political pressure, economic uncertainty, a decidedly insecure Social Security, investment products that make planning harder instead of easier and the risk of outliving their assets, investors and their advisors have to keep several different issues in view whether they’re still planning for retirement or already retired.

To help advisors bring clarity to their clients’ retirement plans, Investment Advisor talked to several of the main players on the retirement stage to get their thoughts on the big challenges of modern retirement.

1. Fiduciary and DOL

Phyllis Borzi, assistant secretary of labor for the Employee Benefits Security Administration, has said that while she “appreciates continued feedback” from the industry regarding EBSA’s previous proposed rule to amend the definition of fiduciary under ERISA, she is “moving on to the publication of a new proposal, and there will be ample opportunity for public comment when it is published.”

Indeed, Borzi has gotten an earful since issuing her controversial fiduciary proposal last year, which she eventually pulled and has since been redrafting. That redraft is scheduled to be released in July, and there’s no guarantee that Borzi and her team will agree to make yet another proposal after the next round of comments flood in.

In an email exchange with Investment Advisor in early February, Borzi would only reiterate remarks she made in December that the new version of the fiduciary rule will prove EBSA has listened to industry concerns. “When people see the reproposal, reasonable people with open minds will say DOL listened, that DOL addressed the legitimate issues that were raised in the long comment process,” Borzi said again. “The reproposal will be better, clearer, more targeted and more reasonably balanced.”

Critics remain skeptical. For instance, Brad Campbell, former head of EBSA who’s now an attorney with the Financial Services ERISA Team at Drinker Biddle & Reath in Washington, said that the changes to the revised fiduciary rule would have to be “quite significant” to address the concerns raised by many service providers, including broker-dealers.

Campbell added that he believes the revised rule proposal will actually become “more controversial” with respect to IRAs.

John Carl, president of the Retirement Learning Center, argued that small plans would face a huge challenge under Borzi’s previous fiduciary proposal. While most firms are willing to have “some higher fiduciary standard for mid- and large-sized plans,” it’s the small plans that will face the biggest challenge. Small plans “are sold, and in order to sell something, there has to be compensation,” Carl said.

But Borzi told Investment Advisor in her email correspondence that EBSA has “never said that people shouldn’t be compensated. As for the effect on the small plan market, we have spoken with individuals in the financial services industry who say they can and do offer fiduciary-level service to small plans now.”

Ken Bentsen, executive vice president of public policy and advocacy for the Securities Industry and Financial Markets Association (SIFMA), stated in mid-January that DOL’s previous fiduciary proposal was “contrary to where Congress wanted the SEC to go in Section 913 of Dodd-Frank.” Section 913 of Dodd-Frank “makes it clear that you could have dual models under a uniform standard of care,” however, “the way the DOL is moving would eliminate the ability to have a commission-based model for ERISA accounts.”

The DOL fiduciary proposal would create “operational challenges” for brokers at the retail level if, for instance, they have a client who has multiple accounts with that broker, including retirement accounts. The broker “would have to operate under conflicting rules from two different agencies for one client,” Bentsen said. —Melanie Waddell

Photo by David Johnson

2. Complex Annuities

In the wake of the financial meltdown that left retirement and investment accounts critically depleted, investors have increasingly sought some way to ensure their so-called golden years won’t turn to tarnished brass. One way they’ve done this is to look increasingly to annuities in their various forms. However, consumer advocates have been ringing alarm bells about the more complex annuity products and their suitability as retirement funding.

Barbara Roper, director of investor protection at the Consumer Federation of America, said that the “annuitization of retirement plan assets [is] an idea many people find attractive. The [ability to] get retirement plan payouts as an income stream over years, instead of as a lump sum, has the potential to offer significant benefits to many individuals.” Gaining an income stream via the more complex annuities, however, could be another kettle of fish.

Although annuities offer the promise of a continuing income stream, their various features and riders can provide more limits than security, she said, and their complexity means customers will have a rough go in trying to find the best product. Roper pointed out a number of factors that advisors and their clients should be aware of in considering an annuity product.

“A huge percentage of annuities,” she explained, “are actually held inside tax-advantaged retirement accounts, so you’re buying a product whose primary benefits are tax advantages inside a plan that already provides those tax advantages. The SEC has said in the past that these are questionable and not appropriate [for a retirement product]. There may be some isolated circumstances in which that might be an appropriate strategy—I wouldn’t say never,” but Roper was still doubtful.

Another caveat is their very complexity. “When you buy an investment, they say you shouldn’t buy it unless you understand what would have to happen for you to make money and lose money. I think too often annuities—at least the more complex exotic annuities […] fail that test. The investor can’t make an informed choice and tell which would be better for them.

“It’s really hard to compare these products,” she continued, “because they’re so complex in terms of the different features they have: minimum withdrawal benefits, guaranteed lifetime payouts. One product could offer a higher percentage gain, for example, and not allow for as large an accumulation because of different features.” There are other hazards hidden in complexity as well.

She cited, as an example, the disclosure about the maximum penalty for early withdrawal in an equity indexed annuity prospectus. “This is an annuity that may tie your money up for years,” she said. “Knowing what the downside is, is pretty important, but it’s an algebraic equation: i equals that and j equals that and m equals this. So they’ve disclosed the calculation that determines the withdrawal penalty, and there’s not one investor in a thousand who would look at that and have a clue what that penalty might actually be.

“The complexity, the less-than-transparent disclosures about key features, the very high costs that are often associated with these products make them highly suspect in our minds,” Roper continued. “Add to that, that they’re disproportionately sold by salespeople who don’t have to act in your best interests—[it makes us] skeptical.”

Roper warned, “Market forces are not operating here. If people who have expertise can’t compare the products and determine what’s best for a particular investor, it means the products don’t have to compete based on being best for the investor. They compete based on paying the salesperson. That to me is a market I want to avoid.” —Marlene Y. Satter

Photo by John Johnston

3. The Feds and the States

Prepare for “a lot of fighting between the industry and the Department of Labor” this year as Phyllis Borzi is “hell bent” on reproposing her rule to amend the definition of fiduciary under the Employee Retirement Income Security Act (ERISA), said John Carl, president of the Retirement Learning Center.

Borzi, assistant secretary of labor for DOL’s Employee Benefits Security Administration (EBSA), plans to repropose the fiduciary rule likely in July and issue an open comment period. Carl told Investment Advisor that while most firms are willing to have “some higher fiduciary standard for mid- and large-sized plans,” it’s the small plans that will face the biggest challenge. Small plans “are sold, and in order to sell something there has to be compensation,” Carl said.

The previous fiduciary draft stated that “any advice on a rollover would also be a fiduciary act,” Carl said. “That doesn’t work on many levels because IRAs are open architecture—you can buy bonds, stocks” and so on, and acting in a fiduciary capacity “would likely limit investment options and access to advice.”

“The same thing applies in the small plan market—if you make [employers] write a big check to start up a plan, they won’t do it, but if they can pay an advisor, [employers] will start one.”

Another retirement planning issue that will play out this year will be the “serious discussions” on Capitol Hill about including retirement incentives as part of any deficit reduction efforts. “I would say it makes more sense to look at the mortgage deduction.” However, Carl said, it’s too early to tell which way Congress will go.

As to solving the retirement deficit crisis, Carl said there is bipartisan support on Capitol Hill for Sen. Tom Harkin’s plan to provide universal access to pension plans through his Universal, Secure and Adaptable (USA) Retirement Funds.

Harkin, D-Iowa, chairman of the Senate Health, Education, Labor and Pensions (HELP) Committee, announced in late January that he would not seek re-election after his 2014 term ends. However, a spokesperson for Harkin told Investment Advisor that he would likely introduce legislation in February to advance his USA Retirement Funds effort.

Harkin’s plan will be two-pronged: USA Retirement Funds—which he described as innovative, privately run, hybrid pension plans that incorporate many of the benefits of traditional pensions while substantially reducing the burden on employers—as well as expanding Social Security benefits by $65 per month.

Similar types of retirement planning options are cropping up in California and Massachusetts. California has passed two bills, Senate Bills 923 and 1234, which establish a framework for a state-sponsored retirement plan for private-sector employees.

With the passage of Senate Bill 1234, California became the first state to create a statewide retirement savings plan for private workers who do not participate in any other type of employer-sponsored retirement savings plan. Also, legislation was passed in Massachusetts in 2012 that allows nonprofit organizations of fewer than 20 employees to set up a contributory retirement savings plan that will be overseen by the state treasurer’s office.

However, the Columbia Learning Center noted that the California Secure Choice Retirement Savings Trust (CSCRST) is “still one giant step away from implementation,” as Senate Bill 923 mandates that the “board shall not open the program for enrollment until a subsequent authorizing statute is enacted that expresses the approval of the legislature for the program to be fully implemented.”

According to the National Conference of State Legislatures, at least 10 other states have proposed the idea of a state-run retirement plan for employees of private companies, including Connecticut, Illinois, Maryland, Michigan, Pennsylvania, Rhode Island, Vermont, Virginia, Washington and West Virginia. Wisconsin lawmakers are expected to introduce a proposal in the near future. —Melanie Waddell

Photo by David Johnson

4. Fixing Social Security

Matt Greenwald has given a lot of thought to the demographics of retirement, and it’s not just because he was born in 1946, the year that the first baby boomers were born. Although the president and chief executive of annuity research firm Mathew Greenwald & Associates is now eligible to begin collecting Social Security, he isn’t yet ready to retire.

If anything, he’s busier than ever. The National Academy of Social Insurance recently hired his firm to conduct a survey of how Americans would like to see Social Security close its funding gap, and Greenwald and colleagues are now conducting their 23rd retirement confidence survey for the Employee Benefit Research Institute (EBRI).

Based on the funding gap survey, one thing is clear: Americans strongly oppose cuts to their Social Security benefits and would prefer increasing the payroll tax rate or raising the retirement age to 68 rather than see their benefits decrease.

On the other hand, the 2012 EBRI study of retirement confidence made it equally clear why Americans so strenuously oppose Social Security cuts: Their belief that they will be able to retire comfortably is at historically low levels, with just 14% of those surveyed claiming to be very confident of having enough money to live comfortably in retirement. A disheartening 60% of workers reported that the total value of their household’s savings and investments was less than $25,000, excluding the value of their home and any defined benefit plans.

As a result, Greenwald said, the No. 1 issue for retiring boomers is Social Security and Medicare.

“Right now, of Americans 65 and over, half of them get more than half of their income from Social Security,” Greenwald said in a recent interview, adding that Medicare is an even greater issue because health care costs are rising at astronomical rates. “The large numbers of retiring boomers create great stress on entitlement programs, and the financial pressure caused by their large numbers is exacerbated by their longer life expectancy.”

Still, Greenwald believes that Social Security is “very easy to fix” and that benefits can be maintained without loss of the cost of living adjustment.

“There’s an earnings cap on Social Security,” he said. “People right now only pay—and I use the word ‘only’ advisedly—Social Security taxes on the first $113,000 of income, which for about 85% of the population is everything. But for the most affluent, there’s a lot of money that could be subject to the tax but is not. Even a gradual increase in the tax would keep Social Security solvent.”

To be sure, raising taxes goes to the center of debate over the future of Social Security, but Greenwald’s greater concern is Medicare’s rising costs.

“Medicare is under severe funding pressure, and the premium cost is likely to go up, especially for the more affluent,” he said. “The reduction of Social Security [benefits] is happening because while [they’re] adjusted up for the cost of living, Medicare premiums are also being taken out of Social Security, and Medicare premiums are going up significantly faster than inflation.”

As the debate rages in Washington over cuts to entitlement spending, millions of boomers now depend on Social Security and Medicare, Greenwald noted.

“There are some projections that in a couple of decades, if things just go as they are, all the money the government collects will be spent on interest on the debt, the military, Medicare and Social Security. What the government could wind up being is a big insurance company with an army, and nothing else,” he said. “Something has to be done. It’s likely that there will be means testing, which means more affluent people will pay more or get less. The key question there is: How do you define affluent? How far down will it go?” —Joyce Hanson

Photo by David Johnson

5. Replacing the 4% Rule

After years of working with clients to develop a financial plan that helps them accumulate enough assets to meet their goals for retirement, advisors can’t neglect their need to decumulate when they’re ready to stop working. The old standby of withdrawing 4% per year, though, isn’t as safe as it was once believed to be.

Michael Finke, a professor in the personal financial planning department at Texas Tech University, called the success of the 4% rule a “historical anomaly” in a working paper published in mid-January.

“The 4% rule was based on the historical asset return in a market environment that doesn’t look like the one that exists today,” Finke told Investment Advisor.

In the new market environment, interest rates are about 4% less than they historically have been, Finke found. When he tied bond returns to current TIPS yields, “which is the best estimate we have on real rates of return on bond investments,” he said, the estimated 6% failure rate on the 4% rule skyrocketed to 57%.

The reason yields are so low is a matter of supply and demand, according to Finke. “We have the largest cohort [of retirees] ever saving and building assets,” he said. It’s not just the boomers in the United States driving up demand. “There’s a large post-war cohort among populations in other countries in the Western world,” Finke added. “There’s also the addition of Asian countries that are dominating the capital markets. They’re all bidding for the same products.”

Furthermore, the United States is a “minor player in the global capital market. What that means is we’re competing with citizens in countries who have a higher savings rate,” Finke said.

Even if current bond yields remain low for the first five years of retirement then return to historical levels, the failure rate of the 4% rule increases to 18%, still much higher than it was in the past. That’s because “the first five years are the most important ones for investment returns in retirement,” Finke said.

“From my perspective, if the emphasis is on safety”—safety meaning not running out of money in retirement, he clarified—“the only reasonable solution is longevity insurance or some kind of deferred annuity product.”

Finke noted, “The possibility of running out of income is what most retirees worry about.” However, “that worry is relatively easy to take care of” if you pool longevity risk among retirees as with an annuity.

Finke referred to separate research from his co-author Wade Pfau who “estimated the optimal investment frontier for retirement.” He found that a combination of stocks and annuities, rather than bonds, provide a more efficient retirement portfolio.

“The other reality is that people need more money to sustain their retirement income. That means they have to save more or work longer,” Finke acknowledged. “It’s depressing, but now is a bad time to retire.”

Another challenge for advisors trying to determine the best withdrawal rate for their clients is the risk of cognitive decline in their clients.

“We’re living in a new era where the responsibility for retirement funding is increasingly on investors. The prospect of cognitive decline is also an essential part of planning,” Finke said. He suggested advisors have their clients designate a friend or relative that the advisor can contact if the client shows signs of dementia.

Similarly, future health care is a serious concern when planning for the decumulation phase of retirement, Finke said.

“Society or financial services providers need to help solve the problem of the small probability of a financially devastating health event,” he said. “One of the biggest questions in most retirees’ minds is about how to deal with prolonged illnesses.” —Danielle Andrus

ThinkAdvisor's TechCenter is an educational resource designed to give you a competitive edge by keeping you abreast of new tech innovations and need-to-know information that can be applied to your business.